How to Be at the Bottom of the Financial Barrel

The past three days I've talked about the book The Difference: How Anyone Can Prosper in Even The Toughest Times by Jean Chatzky. We reviewed the 20 factors that separate the wealthy from the not-so-wealthy, have detailed who the wealthy actually are and how that got that way, and have covered the next-highest group, the Financially Comfortable, and what got them to their lofty position. Today, we'll cover the majority of people in the US -- those barely treading water financially and those in the midst of drowning.

The book classifies these two groups as Paycheck-to-Paychecks (54% of the population) and Further-in-Debtors (15% of the population.) We'll cover each of these groups separately, starting with what makes the Paycheck-to-Paychecks what they are.

The book says that both personality attributes and financial habits contribute to locking the Paycheck-to-Paychecks where they are financially -- living from one paycheck to another, barely getting by, and one financial problem away from money trouble. This said, the book notes that the habits are the keys -- what really locks them into a dismal financial life. Take a gander of what goes into making a Paycheck-to-Paycheck person:

• Overspending is the key reason that people slip from a position of financial security into a paycheck-to-paycheck existence. It's a vicious cycle. Once you overspend, it's tough -- if not impossible -- to tap into the habits that move people into the range of the financially comfortable. Once you overspend, you cannot save habitually. Credit card debt is a savings killer, and only 22% of paycheck-to-paychecks can pay off their balances every month.

• Paycheck-to-Paychecks have investable assets, on average, of $83,000. That number is skewed by what I like to call the "six-figure Paycheck-to-Paychecks." These are the high earners who still can't seem to make ends meet. The folks who feel broke despite the fact that they're bringing in $100,00-plus a year. Fully half of paycheck-to-paychecks, however, have less than $25,000 to put to work to grow their financial futures.

And here are a few tidbits that typify the Further-in-Debtors -- people who are already in a hole and are tunneling down further:

• Less than 1/4 save anything each month or make a contribution to a retirement plan.

• 56% have less than $10,000 in investable assets.

• They're both unhappy and insecure.

• Nearly half get physical symptoms like insomnia, heartburn, stomachaches, or headaches when they think about their finances.

The book goes on to say that Further-in-Debtors blame bad luck for their financial situation. The author blames "hubris," commenting the following:

The Paycheck-to-Paychecks overspend and know they're doing something that's not in their own best interest. The Further-in-Debtors overspend without a thought because they feel entitled. They deserve the nights out, the new clothes, the latest technology. How do I know? Our research gave me a peek into their budgets. A full third devote a decent chunk of their budget to entertainment or extras -- nonessentials as far as I'm concerned. Far fewer devote any money at all to saving for tomorrow.

Here are my thoughts on this subject:

1. I often get ridiculed for saying that spend less than you earn is my best piece of financial advice. After all, the hecklers note, this is "common sense." It's not common sense for 69% of the US population!

2. Yes, if you're overspending, you don't have any surplus to help build your net worth. The only solution is to create that surplus by increasing your income, decreasing expenses, or both.

3. Notice how high-earners can also be in a less-than-stellar financial group? Yep, because even if you make $100k per year, if you spend that much or more you're going nowhere financially (except perhaps backwards.) We've profiled many of these people over and over again here.

4. On the flip side, wealth doesn't require a high income. Even if your income isn't as high as many others, you can still save if you simply spend less than you earn. It works!

5. The Paycheck-to-Paychecks and the Further-in-Debtors are doing the opposite of what it takes to get rich. Is it any wonder they are not making financial progress?

6. Interesting to see how money problems impact people's health. Maybe I should write a piece on "how to become healthy by becoming financially secure."

7. The entitlement (or "I deserve it") mentality is alive and well in the US today. Unfortunately it's invaded our government big-time over the decades and hence we overspend as a nation since everyone "deserves" certain "rights." (Certainly there are people that need legitimate financial help to survive, but this group is much smaller than the one that actually gets aid, IMO.) If the US government was a person, it would be a Further-in-Debtor. Interesting point to consider.

Comments

[David]

This entire series of posts on this book has been fascinating to me. I'd characterize myself as Financially Comfortable but (hopefully) on my way to Wealthy. My wife and I are 32, we own a home, and have roughly $350,000 in investable assets. I'd say I have 18 of the 20 factors. While that might technically qualify us as "wealthy" in the age bracket, I wouldn't consider myself actually wealthy until reaching at least $1 M in investable assets.

One thing that you have NOT addressed, however, and something that I am personally struggling with, is whether someone is willing to make the SACRIFICE necessary to "get to the top." By sacrifice I'm not referring to not buying expensive cars, clothes, and vacations. I mean sacrificing relationships, leisure time, putting more time in the office on nights and weekends, etc., putting on hold having children or making time for children, and generally sacrificing personal (non-monetary) pleasures, goals, hobbies, passions, and relationships.

I've personally encountered many very successful people. In my opinion, for at least 80-90% of them, success required making significant sacrifices to time spent on their marriage, their children, their religion, their other family members, personal hobbies and passions, leisure time, etc. This fits in line with what FMF says--that taking care of your career is critical. It also fits with several of the 20 factors identified (competitive, leader, aiming to achieve $1 million, etc.). And so the question I'm asking myself is, if I can be "financially comfortable" without having to make deep sacrifices, then IS IT WORTH IT to make such sacrifices in order go go from financially comfortable to wealthy?

Now granted, one CAN achieve "wealth" through a 9-5 job and a $60,000 income. FMF has profiled many such cases already. BUT, it usually takes a person an entire lifetime to achieve such wealth (35+ years or more). Most people want to be "wealthy" sooner rather than later. I'm not talking "get rich quick" but I would imagine that most ambitious, driven people would like to be wealthy at least by the time they are 40 or 45. But like I said, in the majority of cases, that goal requires a commitment leading to sacrifices of relationships. I'd love to see Jean Chatzky, other financial advisers, or even this blog seriously address this issue.

[Crystal]

Talking finances with someone in the Further-In-Debtors category is like banging your head against a wall.

For example, some friends from poker and D&D came to me for financial advice more than a year ago. They wanted to buy a home and asked me to take a look at one that caught their eye since my husband and I bought a foreclosure in 2007. I drove with them to the house and saw a bad investment, plus I knew they had lots of debt (I had no idea the amount). The house was more than 30 years old, had obvious foundation cracks, and needed a bunch of expensive repairs.

What I said was, "It seems to have some expensive needs, are you sure you want to put that much into your new home?"
They said, "Yeah, it's selling for $30,000 less than it should. It's a great deal."
Me - "Do you have the cash for it since the repairs probably won't be rolled into your loan?"
Them - "Ummm...we'll get to it little by little."
Me - "Do you need help with a budget?"
Them - "Sure, thanks." We sit down with a pencil and paper.
Me - "What's your current income and your current expenses?"
Them (Her) - "He makes about $65,000 a year as an airplane engineer and I bring in a little for my web designing."
Me - "So like $75,000 a year total? $55,000 or $60,000 after taxes?" They agree. "What kind of expenses?"

They then hit me with two car loans for new Mustangs that are totalling $1100 a month, his student loan debt of about $1600 a month (more than $80,000 total), and some credit card debt.

Me - "You are spending nearly half your monthly income on debt and not making a dent in the student loan principal...that's like a mortgage by itself. Are you sure you don't want to pay some of this off before getting a mortgage?"
Them - "We've been doing so well, we could pull it off."
Me - "I wouldn't try right now. If you rent something cheaper, cut back on spending, and make major headway on the student loans, you would sleep better and be in a better position to buy a house in a couple of years. You don't want to risk losing the house if he gets laid off, right?"

They politely agreed and rolled their eyes (I don't think I was supposed to see that). They thanked me for looking...

How could they even consider buying a house?! Why would they get two brand new Mustangs when they had $80,000 in college debt?! Why try to carry multiple gigantic loans on one real income?! Why ask for my advice if they thought I was a crazy miser anyway?!

Okay, done venting...thanks.

[JimL]

As an associated topic, we keep hearing the comments that most bankruptcy situations are a result of job loss or medical expenses. However, when really looking into it, the real cause is overspending. As we know, many people are living paycheck to paycheck in order to fund the lifesytle that they want. Little to no money is put into savings, so when a major even happens, like the job loss or medical bills, it merely pushes them over the edge. Obviously, if people had built the emergency funds, they could have made it through the tough situations and not resort to bankruptcy.

[Crystal]

@David
My post under "How to be Financially Comfortable" is pretty much me admitting that my husband and I have chosen careers that just don't pay enough to become wealthy quickly. We make $78,000 jointly before taxes, live on $36,000-$40,000 a year, and put the rest towards retirement.

We didn't choose our jobs conciously knowing we would have lots of free time, but that's how it worked out. He's an 8th grade Science teacher that is in graduate school to become a librarian and I have an 8-4 cubicle job. Unless I can find a better job that I'd enjoy more, we probably will never hit a combined 6 figure salary, but compound interest will help us reach our 2-3 million dolar goal in 25-30 years.

In short, due to leisure-time mindsets, we will never be the wealthiest people reading this blog. It's depressing that it will take so long to retire, but we do have a lot of time together along the way...

Thanks for helping me feel a little better!

[FSS]

Overspending is what is keeping persons with limited money management in debt. One need to avoid doing this if he/she want to obtain financial freedom.

[Mark]

Crystal - you should feel MUCH better, not just a little! I don't see anything wrong with consciously deciding to enjoy your leisure in small bites along the way, instead of in one big bite at the end of a long hard worklife - when you may not have the health to really enjoy it anyway.

As long as you know it, and choose it - so what?

I have two siblings who took opposite approaches - one worked VERY hard and "retired" at 35 with several million dollars. After 5 years, he went back to work. Why? He'd had his fun, and it wasn't so much fun when it was full-time.

The other works just enough to get by. He's a fully-qualified professional who had his own practice for a while, but now quite deliberately works just enough to support a very simple chosen lifestyle. When he needs a new bicycle, he works a few extra days to buy it. If he wants to take a month off altogether, then he works a little extra for a few months first.

Which is "better-off"?

[Crystal]

@Mark
I see your point. I seem to be in the middle. I want to retire as early as possible without giving up much more time to work (40 hours a week). That's why I'm so savings-oriented...it's my compromise.

I would not mind working more for a better salary/benefits combo in a job I'd like, but I have not found that job yet. I only make $35,000 a year but my benefits are covered completely and the 401k is matched 100% up to 6%. It's flexible and I get to have a life. It's hard to give that up.

I either need to change my mindset and just accept myself as I am now or give myself a kick in the butt to "live up to my potential" as my mom would put it. So far, I'm leaning towards staying put...

Thanks for the post! I do feel alot better!

[D]

After reading these articles I have become aware that I am somewhere in the middle. I make a decent paycheck, but the standard of living in this area is crazy. I feel like I put everything into savings but don't see the results just yet... To all readers I propose this question:

I am about to get married, I am a 31 year old in the IT field within the metro DC area. I bought my condo in 2004 and have since put a lot into fixing it up. However, with the market crash do you think it is wise to put more towards the principal or sock that away in savings for our next places down payment? What will give me more bang for my buck? The details are this:

Mortgage: $1,450
HOA dues: $270

I am now putting $2,300 into the Mortgage every month and anything left over into savings / retirement (about 35% of pay)

Would it be more wise to put the Mortgage payment back and start pumping up my "Next House Downpay Fund" ???

Thanks everyone,

D

[D]

Correction:
put the Mortgage payment back = PULL the mortgage payment back

[David C]

I know a lot of folks who truly live paycheck to paycheck, literally. I live on a sort of self imposed paycheck to paycheck lifestyle. I have a set amount budgeted to bolster the emergency fund(it will never be big enough to satisfy me LOL), utilities and insurance, a small amount for "mad money" and everything that is left goes to debt reduction. If we are lucky we can have our "bought right(as in not too much house and got a great deal)before the whole housing fiasco" home paid off in less than ten years. Then I will feel financially secure.

[Crystal]

@D
I personally lean towards paying off debt. I hate owing money.

Also, we are making a tiny 1.3% in our ING Direct Savings account right now, so I would definitely put extra money towards the mortgage.

[MC]

@David: I agree that some kind of "sacrifice" is generally required at some point if you want to be comfortable.

For example, getting that good education that can lead to a good job takes an awful lot of work even if you have significant native intelligence. Getting high grades on a hard degree from a good college is not easy--you have to really put off having a social life and study hard most of the time you're in school. Similarly, graduate school was a slog for me--I worked on my thesis 16 hr days 6 days a week for 5 yrs, and lived on only $10K/yr (my stipend) during that time. And after that, you have to work hard some more on your career or it's going to go nowhere.

The sacrifices are particularly noticeable in my field (biology/medicine) if you are a woman: you're not going to get tenured until you're at least 40. And until you're tenured (or if you never are), you'll be making $40-60/yr (and be on a year-to-year contract often without health benefits) even though you have a PhD. Good money, sure, but not what you'd hope to get from 5 years of graduate education. Go for the 2 year MBA instead. In contrast, if you are tenured in my field you can expect $100-1000K/yr depending on whether you are working in academia of the pharmaceutical industry--ie a little more in line with all that education.

So when do you have kids if you're a woman in this field? If you have kids before 40 there's a chance you won't get tenure because you can't get the amount of work done that is required. But if you wait to have kids until after you're tenured...well, there's the biological clock. I was lucky--I had twins when I was 39 and I got tenure (at 43) anyway. But it definitely wasn't easy and I didn't even have a maternity leave let alone much time at home with my kids while they were young.

Unless you are willing to make the sacrifices to get to the top, I wouldn't recommend anyone going into my field. Just my opinion.

[D]

@Crystal

My reasoning for not paying off my Mortgage debt more quickly is that the value of the house will not increase thus losing out on the interest that I could have made if I had 'put it away'. If my condo value stays where it is and I pay it off month after month, I'm getting a $1 for $1 average. However, if I take that same money and put it away I could earn maybe 2 - 3% off of it, thus increasing my overall account which I can then pay off more principal or put more towards a down payment on another place. Its a risk; if my home value goes up by more than 3%, then I am "losing money" (assuming my Money Market is still returning 3%), but in this economy there are too many uncertainties.

[David]

@Crystal, I agree with Mark, you shouldn't feel bad at all! Personally, I've experienced both sides of the leisure vs. sacrifice fence. Early on, my wife and I both took high paying but very demanding jobs that we've worked in for the past 6 years. High income, but long hours and no life. We went into it consciously knowing that we weren't going to be doing it forever and that we wanted to start our careers with a good amount to save, but it was still a very long six years. Then we had our first child and we both knew it was time to leave. Since then we've both found lesser paying but less demanding jobs and haven't looked back. Now it's going to take much longer to get to our financial goals, but having the leisure time to spend with friends and family along the way makes it very worthwhile. As I see it, your personal life is like sleep. You can't just forego sleep for a year and decide you'll just make it up by sleeping 3 straight weeks after. Doesn't work that way.

[Jim W]

I am happy to see someone finally mentioning the "entitlement mentality" so prevalent among the financial idiots in this country. Based on my observations, most of the Further-in-Debtors have had plenty of money go through their hands to pay for luxuries, lottery tickets, casino gambling, etc. If this money had gone into a bank CD instead of being squandered, most of them would not need to be constantly looking for a new government handout at the expense of citizens who did the right thing all along. Unfortunately, "populism" makes it very profitable, in terms of garnering votes to stay in office, for politicians to pander to the low-lifes and come up with more and more "income transfers" to shield them from the life of penury that they deserve. Class warfare is more alive and well than ever before, thanks to the present left-wing government of Obama, Reid, Pelosi, et al, and the pandering to our basest element is going to bring America to its knees sooner rather than later.

[Crystal]

I agree there will be "sacrifice" as some point, but it is much less if you need less to be happy.

I lived on very little throughout 4 years at college, but have not had to sacrifice much to live like I want since then. I enjoy hanging with my husband, friends, and family (in that order, lol). I also enjoy my dogs, books, movies, and tons of tv. It's a simple life, but I don't feel like I'm missing out on much.

Sure, winning the lottery would be awesome since I'd be able to travel even more than the 1 or 2 major trips we take a year since I'm limited by my 10 vacation days. But I never wanted a sports car or a mansion, so I feel pretty fulfilled...

I guess my point was that if you enjoy your job, then sacrificing for it makes sense. If you only like your job for the paycheck, I would adjust what else I want so I don't need such a large paycheck. It's all about what you want from life.

@MC I really hope that you love what you do! Dang you went through a lot to get where you are! And twins! Just wow!!! I'm impressed and exhausted just by thinking about it...you go girl!

[Crystal]

@D
I understand your financial reasoning. I just hate debt. Plus, I've never known anybody who was hurt financially by paying off debt (as long as you already have an emergency fund and whatnot)...

Does anyone else have any ideas for D?

[Crystal]

@David
Thanks for another vote of confidence! I feel 100% better than I did when I started judging myself. Thanks!

[D]

@Crystal
I completely understand where you are coming from. I hate debt as well. I'm just worried about which will give me "more bang for my buck". Either way, I am paying down my debt, its just a matter of how quickly I pay it off. ($1500 or $2300, both are above the 'minimum' payment). I'm just wanting to get into a new place sooner than later and start my family :)

[Apex]

@D,

Good news, if you actually are saving exclusively for the next house and that money is going into straight savings at currently 2-3% I can guarantee you that putting it into the house is better, actually makes you more than saving it and I can prove it.

You have made a math error in your reasoning that if you put it into the house your return is based on the appreciation of the house. First of all, you get all of the appreciation from your house whether you put any extra money in or not.

For example. If you owe 100,000, don't pay one extra penny (assume no interest on either the mortgage or the savings to make easy math) and save an extra 10,000 in savings and then sell the house for 120,000, you walk away after sale with 30,000 (120,000-100,000 + 10,000 in savings). If instead you put every extra penny into the house you walk away after the sale with 30,000 (120,000 - 90,000 the new debt after putting the 10,000 in the house instead of savings)

So now we see that the way you make money by putting it into the house is not apprecation (you get that whether you put in extra money or not. So how do you make it then.

You make it by having less outstanding principal that has interest due on it.

If you put money into a savings acount at 2% you make 2%, but if you pay off more of your house loan that reduces the principal on your house that you are paying interest on and presumably you are paying 5-6% or maybe more. So by paying that balance down you are effectively making 5-6% return on your money. Amortization tables are complicated and hard to make the example clear so lets just talk about the case of a situation where you got 10,000 extra dollars to pay towards your loan or save 1 time and every other time you just paid the minimum payment (lets assume an interest only loan to keep the math simple again).

So you have a 100,000 mortgage and your interest rate is 6%. This results in a 500 dollar a month payment (the interest only). Now after a couple months you get a 10,000 dollar bonus. So you use that to pay down your mortgage leaving a balance of 90,000. Your new interest only payment in this example is now 450 dollars per month, meaning you have made 50 dollars a month in saved interest by paying down the loan balance. In a typical 30 year fixed loan you would keep throwing the same money at the mortgage and thus this 50 dollars further pays down the balance saving you even more.

If instead you saved the money in an account making 2% interest you would now make $16.67 per month in interest, which is only 1/3 of the money you earned by paying down your mortgage (which makes sense because 2% interest on your savings acount is only 1/3 of the interest rate on your mortgage).

So the choice is quite clear.

Now there are other reasons you may not want to do it like making sure you have money saved in an emergency fund or if you wanted to save money for something else because if you don't sell the house pulling the money back out will not be easy. But if you truly are saving this specifically for the downpayment on your next house, the best return on your money is an easy choice and that is definitely to put the extra money into the house payment as that is what gets you a much higher interest rate return on your money.

The rule of thumb for whether you make more paying down the house mortgage or saving is easy, compare the interest rate on savings account versus the rate on your house. Whichever is higher is the better deal. (this assumes zero tax consequences because of the mortgage interest deduction). If you aren't getting the mortgage interest deduction because you don't itemize then its even more beneficial to put it in the house and you would actually need to get about 25-33% better interest rate outside of the house to break even if you were not getting the mortgage interest deduction.

[Apex]

@Crystal

"Why ask for my advice if they thought I was a crazy miser anyway?!"

You kind of answered your own question with your opening sentence about baning your head against the wall. The further in debtors did not ask for your opinion because they thought you were a crazy miser. This was a revelation to them after you told them the facts. These people live their lives just doing and getting what they want and assume that there is always an easy way to make things work out. You have proven to them you have been able to be responsible with money so in their mind you must have some experience in this area and can share with them the easy way to make this work out.

You will notice at every one of your concerns they brushed it off and had an easy answer that was basically of the type "we will make it work out somehow." So these people don't actually want to plan the finances out and find out what they could make work or how to get to the point that it could work. They have never done a single thing in their life that way. They just do what they want and react to the consequences later and muddle through. This is how they expect life works.

When you showed them how they needed to approach the situation they realized that you have not yet figured out the magic easy formula they are convinced exists. It's possible they walked away realizing it doesn't work that way but likely they just walked away thinking you live a meager miserly life (as you said). There are only 3 things I can think of that they would walk away decided to do after that meeting.

1. Ignore your advice and do it anyway.
2. Ignore your advice and go get a second opinion that is more to their liking.
3. Ignore your advice and decide they just aren't going to get a house for the time being then because the path of saving that you suggested to get there is definitely not something they are willing to cramp their lifestyle to achieve.

Regardless of their decision it likely always results in first ignoring your advice. And thats the depressing thing about trying to help these people. My brother ran a financial advice seminar for many people in his church who were in very tough financial situations. He made it clear that he was going to show everyone in the seminar how to get their finances in order and move towards financial freedom. It was by volunteer and went for about 10 weeks. People were eager to sign up and very excited about it. By the end only 1 even attempted to do his advice and he didn't follow through. It was so clear they were all looking for the silver bullet and when they saw what it would take they either decide I can't "afford" to do that or even if I could do that, there is no way in HELL that I am doing that. The people were all very disappointed. It was clear they had expectations that my brother had learned the secret and he would now share that with everyone. When they learned he just had basic sound financial money management principles to share, I think they probably actually felt duped (it was a free seminar) but they just were looking for the secret. There is no secret. Just common sense, which is extremely uncommon among the masses.

[Old Limey]

In order to not perpetually be at the bottom of the financial barrel it helps enormously if at least one person in the family has some Math skills. Let's examine just one example out of many that come up during your adult life.

Let's take a mortgage for buying a home. My Credit Union has calculators on its website for all manner of financial calculations, but you do have to understand some simple terminology and to understand how things like the amount you are borrowing, the amount of your monthly loan payment, and the interest rate, assuming that you have a straightforward fixed rate mortgage, all figure in to what you can afford and what it is going to cost you in the long run.

If you run through the calculations you will find something that many people don't realize when they sign on the dotted line.

First examine a 30 year fixed rate mortgage.
If you borrow $100K at 5% you will pay back $193K --- Monthly payment=$536 --- Total interest=$93K
If you borrow $100K at 6% you will pay back $216K --- Monthly payment=$600 --- Total interest=$116K
If you borrow $100K at 7% you will pay back $240K --- Monthly payment=$666 --- Total interest=$140K

Now compare this with a 15 year fixed rate mortgage.
If you borrow $100K at 5% you will pay back $142K --- Monthly payment=$789 --- Total interest=$42K
If you borrow $100K at 6% you will pay back $151K --- Monthly payment=$839 --- Total interest=$51K
If you borrow $100K at 7% you will pay back $162K --- Monthly payment=$900 --- Total interest=$62K

What surprises many people is how much interest you end up paying on long term loans.
Borrowing $100K at 6% will cost you an extra $116K over 30 years with a monthly payment of $600.
Borrowing $100K at 6% will cost you an extra $51K over 15 years with a monthly payment of $839.
Bottom Line - paying an extra $239/month in this example saves you $65,000. This is where frugal people win out every time over non-frugal people.

These are the type of calculations you need to make when determining how much 'house' you can afford to buy, how much of a 'monthly payment' you can afford to make, how much interest you will be paying over the life of the loan and how a shorter term loan can save you a lot of money in the long run.

This is not about having to be a college Math major, but it is about the need for some Math skills and not being like some sales clerks that need an electronic calculator to figure the change when you hand them a $5 bill and a quarter for an item costing $3.17.

[David]

@Old Limey, all true except you're not taking into account opportunity cost. Also, typically 15 year rates are higher than 30 yr rates.

So taking your example, if you have an option to borrow $100k at either a 15 yr fix vs. 30 yr, you would likely need to decide between a 30 yr $100k loan at 5% vs. a 15 yr $100k loan at 7%. Under that scenario, using your numbers, you're still paying $31k more w/ the 30 yr loan overall. ($93k - $62k.)

However, then you need to take into account what to do w/ the savings. In other words, under the 30 yr mortgage you're paying $536/mo while under the 15 yr you're paying $900. If you opt for the 30 yr, your monthly payment would be $364/mo less than under the 15 yr. The question is, what do you do with that extra $364/month? If you consider yourself (or know someone who is) a hotshot investor, and you can get a substantial rate of return on that extra money -- say 10% a year after taxes -- then by the end of the 15 year loan, you'd have made $79,513 in profit. Significantly more than the $31,000 you would have saved by going with the 15 year loan.

[Clint]

David, Have you been smoking again? 15 yr rates are always lower than 30 yr rates!

[Old Limey]

Clint:
You're quite right!
Today's quotes are 4.709% for the 15yr. and 5.196% for the 30yr. There's more risk involved when you loan someone money for 30yrs than there is for 15 yrs.

The other thing I should have mentioned about avoiding being at the bottom of the barrel is that in addition to having some Math skills it is very important that you have skills in reading and comprehending the English language, without that you are setting yourself up to be taken advantage of by less than honest realtors and mortgage brokers as has happened a lot during this recession. Just walk around a shopping mall in Los Angeles these days and you will think you're in a foreign country whereas in other parts of California you will hear English spoken using a vocabulary that is almost incomprehensible. Where I happen to live in Silicon Valley our Adult Education Center offers many classes in ESL (English as a Second Language) and the cost is only $2 for each 2 hour session so you can't blame the system.

[Crystal]

David, I'm with Clint, 15 yr rates are definitely lower. We would have had a 6.5% rate for a 30 year loan and 5.375% for 15 years...that actually made up our mind for us. :)

[Terry]

Upon reading "wealth doesn't require a high income" for the umpteenth time, I really really wanna know:

What is the minimum income required to acquire wealth?

I don't think a minimum wage income is sufficient.

[Eye-Rolling-Son-In-Law]

I think that F-I-Ds are fascinated with the trappings of what they consider the good life, and I think this is a key attribute of the mentality the book describes. Not only do the F-I-Ds need to have the good life trappings, they must have them NOW. They derive abnormal levels of pride from their possessions, and experiences that they consider to be high-class.

My father-in-law is a F-I-D. He has virtually no retirement savings, but he has purchased two $3000 china cabinets for his plates. He buys his plates from a fancy hotel that he cannot afford to stay at when he travels. He flew to England to take a transatlantic cruise to New York on the QM2 a few years back.

At the same time, the tile walls in his downstairs bath are half gone due to water damage. Why you put fine furniture in a house where you'd be embarrassed for an overnight guest to shower is beyond me, but it makes sense to him. Honestly, I don't think he sees the decrepitude of the house anymore, but he beams when he turns on the LED lights over his overpriced plates.

He inherited about $30k a few years back, and instead of paying down debt or fixing his house, he promptly put it all towards a unit in a terribly executed condo/hotel venture with a hotel that has a reputation for poor customer service. The condo is not in a tourist location and is almost 300 miles from his home. He could rent the condo for revenue, but chooses not to. I asked him why he got the condo if not to use it sometime and rent it most of the time. For pride, he said. His family once had a farm, and he romanticizes the idea of owning land.

I think that somewhere along the way, many F-I-Ds lost the ability to be content with good, solid, simple possessions or find meaning in experiences without spending money. For them, the difference between cheap, inferior goods and decent, middle-class possessions is nonexistent. All they can measure is the luxuries they deserve, and the inferior stuff that everyone else must suffer and get by with.

My father-in-law is a well-meaning guy with a lot of money problems that I hope to protect my family from in the years to come. He lives in a house that is slowly falling apart, with no financial security and creditors calling him repeatedly at home.

But in his mind, he's part of the noble gentry, with his fancy dishes, hand-crafted furniture, rolling acres of land, and summers on the high seas with his peers.

[Mike Hunt]

The P-2-P and F-I-D group is exactly what the Suze Orman show is for. Basically folks lacking the basic math skills on what is affordable or not. Sadly this group is a target audience for all sorts of industries: mortgage brokers, car salesman, marketeers, credit card companies, etc. Actually this group was engaged by GW Bush when he told everyone to go out and shop after 9/11. The good news is with some quick education this group could get their act together and do much better if they have the desire to change.

@ Crystal & Clint- the yield curve used to be inverted so about 1 year ago 15 yr mortgages may have been more expensive than 30 years. At present the yield curve is shaped more conventionally and the 30 yr is more expensive than the 15 as you correctly state.

@D- May I ask how much equity do you have in your home? How much is the home worth right now and how much is your mortgage? If you are underwater with no equity I guess you may have a strategy to save up money, make a down payment on a new house and then default on your current place? Actually this makes financial sense but many would say this is unethical. If you have equity in the home, are not underwater then why are you looking for another place? Do you need more space to grow into? If not you should stay in your current place and pay off the mortgage quicker.

My rule of thumb is get the smallest place you are comfortable occupying, because the utility bills will be lower, property taxes generally lower, it will be easier to clean, and it will be tougher to increase your possessions (most of which you don't need but if you have a large place are compelled to fill it).

Only move into a larger place when you have children and/or other family members moving in.

An added bonus of having a smaller place is the mother in law hasn't moved in. She lives nearby and would surely move in if we had a much larger place. As the space is tight she only stays with us overnight occasionally. Aah, life is good!!!!!!

-Mike

[Mark]

@Old Limey - I have to disagree with your conclusions on mortgages. I have recently done the calculation for the mortgage I am taking right now. With rates so low, even a 0.5% difference between 15 and 30 year doesn't make the 15 better for me. Here's why: Mortgage amount: 417K - maximum conventional. 30-year, 5%: Payment = $2239 per month. 15-year 4.5%: Payment = $3217. Difference = $951.

IF I save the $951 each month, and can generate a compounded return of just under 6%, it will have grown to $2239 after 15 years, i.e., it will be available to pay the next payment on the 30-year. Repeat 180 times (every month for 15 years) and mortgage is paid off.

This ignores tax effects but they pretty much cancel out. The mortgage interest payment generates a tax break (at 35% if you earn a lot), and the dividends/capital gains on the savings are taxed at 15%.

By the way, this only works because interest rates are low. If they increase, the required return on the savings gets too high to be achievable. It took me several evenings with Excel to convince myself of this.

Further benefits of the 30-year:
1. If you need the extra $1000 for something else, it will be there (i.e., flexibility).
2. If inflation increses (which I'm assuming will happen within 10 to 15 years due to govt deficit spending), my $2200 per month payment is going to feel very cheap.

I also convinced myself that it is worth paying 1 discount point, and foregoing the interest rate reduction the mortgage companies give if I escrow insurance and property tax. (I am in Texas where property tax is high.)

[Mark]

@Terry - read Nickel and Dimed. You'll soon see that there IS a certain minimum income required to generate wealth.

How much? Well FMF is right - you need to spend less than you earn.

You would need to figure out just how cheap you can make your accomodation, food, clothing, and transportation, and don't plan on having any major (or minor!) medical issue. Did I miss any basics?

So = cheapest apartment (can you share with someone or sponge off a relative?), all self-cooked food, clothing and a bicycle from Salvation Army and Goodwill. Add it up, don't get sick and save the rest.

[D]

@Apex
Thank you for your thorough explanations. I will keep paying more into the house... I'll also contact a financial adviser and discuss with him

Thanks again

D

[Concojones]

@David: In reply to your question "is becoming wealthy/successful worth the sacrifices?": It really depends on what you want out of life (and the sacrifices involved: they vary). Money alone may not be worth a lot of sacrifice (judge for yourself), but add career satisfaction and you may decide that some degree of sacrifice is worth it. In the end, it's all about prioritizing. Sometimes you can have your cake and eat it, but often you can't, and then priorities help to keep your mind sane. :-)

@Old Limey: math, and common sense. I sometimes think this country is one of smart people with an edge selling stuff to gullible people. It's a jungle out there.

@Terry: Mark is right. And live close to work so that you can sell the car and bike instead.

@Eye-Rolling-Son-In-Law, Mike: hahaha, fun comments!

[Apex]

@Mark,

You are correct.

IF:

You can get 6%.

And

You actually save it. All of it. Every penny. Every month. For 15 years.

Not saying you can't or won't. But none of the FID and PTP people will.

[Dave]

@Old Limey,

Oops, sorry you're right. 15 yr interest is lower than 30 yr rates.

My general principle is the same though. If you pay the lower monthly rate under a 30 year fixed, you can reinvest the extra capital in other areas with potentially higher rates of return.

[Yo Prinzel]

Great post. I think it's the further-in-debtors who make me saddest. I was one of them once. Early twenties, everyone else seems to have so much more than you--you work hard, just as hard as them--shouldn't you be able to buy nice things too?

I've found that turning budgeting and saving into a competitive game with myself works really well. Since pride is one of the issues affecting these folks, turning it into a game/challenge allows them to remove any potential feelings of embarrassment at saying no to dinners out, extravagant trips and shopping excursions.

[Old Limey]

@Mark
You stated the following:
"IF I save the $951 each month, and can generate a compounded return of just under 6%, it will have grown to $2239 after 15 years, i.e., it will be available to pay the next payment on the 30-year. Repeat 180 times (every month for 15 years) and mortgage is paid off."

30 year loan --- 2239 x 12 x 30 = $806,040
15 year loan --- 3217 x 12 x 15 = $579,060
The difference is a guaranteed saving of $226,980 and your house paid off in 15 years.

If you go with the 30 year loan and save $951 every month where are you in 15 years?
1) You still owe far more than half of the loan amount.
2) You have saved $171,180 which invested over 15 years at 6% will have grown to about $205,000 because your savings start at zero and then increase by $951/month until the amount you saved reaches $171,180, so the whole amount is not earning 6% for 15 years.

Bottom line - You will still owe well over $208,500 (half the principal) and you will have savings of $205,000 so it's a wash.

The problems I see are:
1) Do you have the discipline to methodically save the $951/month every month for 15 years rather than spend it?
2) Where are you going to invest to earn 6% interest? You cannot get this in a FDIC insured CD so you have to go into the bond market and invest in a total return bond fund. These bond funds have a long term historical return of around 6% but the future is never certain. This interest is also taxable.

The advantage of the 30 year loan is that it gives you flexibility in case of unforseen circumstances where you really need that $951/month. You will also be buiding up equity in your bond investment so that in an emergency you will have a considerable sum of money available. Most mortgages also allow you to send them extra payments from time to time which go into principal and shorten the length of your loan.

If you are a young man with the responsibilities of a wife and children and in this uncertain job market it may be good for you to have the flexibility. I have some money in a total return bond fund called TGMNX, Pimco has a similar fund called PTTDX. Over the last 10 years they have returned over 6%/annum - currently they are doing much better than that - but like any bond, their value fluctuates from day to day. I would also look into prepayment penalties with your loan, probably after a certain period there are no prepayment penalties so that would also give you the option of paying it off at some future date.

I must admit that I used 30 year loans when I was a young man for the same reasons you are discussing.
Flexibility
Lower monthly payments
Being responsible for your own saving rather than having the mortgage company do it for you.
You pay for the flexibility but you never know when you may need it.
One of the greatest feelings in the world is when you finally BURN your mortgage and become debt free.

[Old Limey]

@concojones
You are correct, it is a jungle out there, full of predators waiting to take advantage of the most vulnerable.

The weapons you need to combat these predators are:
A good education.
Good math skills, and also computer skills if at all possible.
Knowledge and experience where money is concerned, i.e not acting like you were born yesterday.
The ability to read, write, speak, and comprehend the English language (especially the fine print).
Know that if something sounds too good to be true - it always is.

[Crystal]

@ Mike Hunt
A 15 yr mortgage rate has been consistently less than a 30 yr mortgage rate for at least the last 3 1/2 years. We started house hunting and looking into mortgage rates in early 2006, bought our home in early 2007, and have been looking at the rates since then in case they fell enough to make refinancing make sense.

[D]

@Apex
After re-reading your post about my house issue I had a question. your assumption is that my place will appreciate. What happens if it does not, as this could be the case when I go and sell. Is it still more wise to put money into it vs. saving it?

Thanks

[Crystal]

@Mark
Maybe due to the flexibility benefit alone, taking a 30 yr loan instead of a 15 yr loan makes sense on a big mortgage. BUT, on a smaller mortgage, like $100,000 or even $200,000, the difference between monthly payments is small enough that the flexibility issue has no pull.

$100,000 30 year loan at 5.5%: $567.79 ($104,404 Total Interest)
$100,000 15 year loan at 5%: $790.79 ($42,342 Total Interest)

Difference of $223 a month and $62,062 in Interest.

$200,000 30 year loan at 5.5%: $1135.58 ($208,808 Total Interest)
$200,000 15 year loan at 5%: $1581.59 ($84,685 Total Interest)

Difference of $446.01 a month and $124,123 in interest.

The flexibility of having an extra $223 or even $446 doesn't justify to me a 30 year loan...not to mention the huge difference in the amount of interest paid. Even if you religiously invested the difference, why give up a guaranteed return of 5% and a paid off mortgage in 15 years?

[Old Limey]

@Mark
One thing I forget to mention is this.
If you do decide to use a total return bond fund such as TGMNX or PTTDX to invest the $951/month the charts of funds such as these that are shown on the Internet in Yahoo/Finance and other sites generally do not take into account that the interest they pay every month gets reinvested into additional shares so the performance they show only reflects the daily changes in the price of the bond.

However if you go to fidelity.com and select 'Research', then 'Mutual Funds', then enter the fund symbol, then click on the fund name, then select 'Chart' you will get a chart that correctly allows for the reinvestment of dividends. For TGMNX for example it will show that $10,000 has become $20,000 over the last 10 years which is close to 7% compound interest.

There's also another class of the same fund with the symbol TGLMX that is a transaction fee fund but with slightly lower expenses and a slightly better performance. Check with your broker about transaction fees because they vary a lot from one brokerage to another.

[Rick Francis]

@Mark and
@Terry

Instead of Nickeled and Dimed, read Scratch Beginnings - it is a much more positive book on the same topic. The author starts with nothing but makes significant process by making sacrifices and working. Yes, health issues are a huge risk especially for those starting at the bottom as they are unlikely to have any health insurance or sick leave.

>save the rest.
Actually Invest the rest! Saving in a regular savings account will NOT be sufficient unless you have a really large income or really small needs.
You need to invest- either in yourself or other businesses. You can invest in yourself with more education, your own business, better tools for your job etc. anything that either boost your income or lowers your expenses. Invest in other businesses though buying equities and bonds.

Rick Francis

[Apex]

@D,

Thats a very good question. And the answer is MAYBE :)

So if you have very little equity in now and you feel it could depreciate enough that it would be a better choice to walk away and let the bank forclose then no, you should not put in a single extra dime. However realize this scenario means you likely can't get a loan on a new house for atleast 3 years if not more because your credit will be shot.

If however you already have a decent amount of equity in and don't expect it to depreciate more than the equity you already have in then the math is the same.

If you owe 100K and its currently worth 150K and you have enough extra money to put lets say 30K more in over the next 3 years but it also loses 25K in value in that time its the same either way. If you keep the 25K in savings then you sell for 125K less your 100K mortgage for a 25K profit plus your 25K in savings to have 50K to put down on a new house. If instead you put the 25K into the house then you sell for 125K less the 75K you put in and you still have 50K to put down on the new house. (Of course this assume no interest again and you would have slightly more than 50K with interest in both cases but would do a little better putting it in the house because the interest savings there are more as per the last example I gave).

The real issue is the other example where you have a 100K mortgage and a 105K valuation. If you save 25K in a savings account and the property decreases to 80K then you walk away from the house, get forclosed, ruin your credit and keep the 25K in savings. If instead you put that 25K into the house and it depreciates to 80K now you sell for 80K less the 75K of the paid down mortgage and only have 5K left. But this is only true because your had so little equity in to start with. It sounds like you probably already have decent equity so unless it was going to depreciate a significant amount more than the equity you had in it you would still come out ahead putting the money in the house.

And just to review again, the only way you come out ahead not putting the money in the house is that you have to let the bank forclose and ruin your credit and keep your savings because it depreciated enough to eat up all the extra equity you had in it.

[Apex]

@D

in my previous example I said you had an extra 30K to put in by in my math I only used 25K. The math is the same but don't get confused by that mistake I made. My math assumes you had 25K extra to put in over the next 3 years.

[Mark]

@Old Limey, Crystal, Dave: I am not that young (almost 50), and I have enough funds and income available that I could do any one of the following:
1. Pay cash for the house,
2. Take a 15-year mortgage,
3. Take a 30-year mortgage,
4. Any combination of the above.
So I had to think pretty hard before quite deliberately choosing to take on the 30-year mortgage.

The flexibility I refered to is really tied to what Old Limey pointed out. It's not just the $951 per month (which would be even smaller with a smaller principal amount). It's the fact that after 15 years, I will have savings of $205,000, which will be generating enough income that I can spend down the $205K fund over the following 15 years paying off the loan.

@Crystal - you asked why not take the 5% guaranteed return? Only because I would rather shoot for the possibility that I might get more on another investment. I see the fixed payments as a way to hedge against future inflation. I know there is a risk that I won't do better than 5%, but over a long period I think the odds are in my favor.

I'm know my decision is not right for everyone - It took me a long time to convince myself to take a loan with a higher interest rate (30 yr) instead of the lower one (15 yr). If the interest rates were equal, it would be easy to choose the 30-year - simply adding principal each month would make it a 15-year.

In the past, I paid off mortgages as fast as I could - adding extra principal every month until I was done, but now my strategy is completely reversed. If there was a 50-year loan, I would probably take it!

The factors that made me do it differently this time:
1. I am comfortable with the risk of putting the money elsewhere. (If you put all your money in one big bucket, you can think of your mortgage as a loan you use to fund your 401k, emergency fund, non-retirement investments, etc, etc. In the extreme case, the apparently safest option would be to take all that money and pay off the house instead.)

2. I expect future inflation. If I'm right, the 30-year is a great deal. If I'm wrong, then it's not a terrible one.

We're way off the topic of F-I-D's, so maybe FMF should rein us in and put this disucssion somewhere else.

[Apex]

@Mark

I agree with your analysis.

I am also bothered by those in the mortgage industry who use just the interest savings over the course of the loan to compare the benefits of the 15 year with the 30 year loan. Showing how much interest you pay on a 15 year loan versus a 30 year loan ignores present value versus future value of money and from a finance standpoint that is not an accurate assessment. The reason is that it's not how much interest you pay, but what is the overall affect on your financial well being or net worth in the long run between the two choices. That impact cannot be summarized simply by the difference in interest you would pay on a 30 year versus a 15 year.

With interest at half century lows, locking up mortgages for long periods of time at low rates is likely either a great idea or a not so bad idea from an investment standpoint. So if you have other productive things to do with the money it's probably a pretty good idea. If you don't then maybe not so much. But the difference in interest alone doesn't tell the whole story.

[Terry]

Rick -

I read the first part of Scratch Beginnings - a little past the bit where he told off the employer with the baby clothing (?) store - and I note that the author was young and had a strong back (hence his ability to do moving work).

Well I'm considerably older and can no longer do that sort of heavy lifting. So I think the author started out with some advantages that bottom-workers often don't have.

[Crystal]

Terry, we get it, you can't be wealthy. Yay, you win.

[Mark]

@Terry - I guess that's why FMF and others emphasize starting when you are young and still have your health.